The Reagan administration is proposing a momentous and far-reaching change in business taxation. With only minor initial effect, it would cost the Treasury $60 billion in lost revenues in 1986 and the amount of the annual loss would continue to grow rapidly after that.
The new "10-5-3" or "accelerated cost recovery system" would junk traditional business tax deductions for depreciation. It would substitute tax write-offs at accelerated rates of 10, 5 and 3 years for most nonresidential property. To sweeten the package further, current restrictions on the investment tax credit would be eased. The ostensible purpose of all this is to compensate for effects of inflation and to stimulate business investment in plant and equipment.
In work with Robert Chirinko for the Office of Tax Analysis of the Treasury (released last month as OTA papers 46 and 47), I undertook a careful, critical examination of 10-5-3, along with other investment tax incentives. We found little evidence that a dollar of lost tax revenues from 10-5-3 or the investment tax credit would ultimately gain more than 40 cents in added investment. It would be more cost-efficient to have the government buy the new plants and equipment and give them to business.
But even that estimate overstates considerably the potential of 10-5-3 to increase business investment now. In an effort to soften the fiscal impact, its framers have provided for a "phase-in" process. Thus anyone contemplating building or buying into a new shopping center for tax shelter and capital gains would have reason to delay investment until 1985, when it would be subject to the most favorable tax treatment.
This program to stimulate business investment thus paradoxically may reduce it during the critical next four years. Yet eliminating the phase-in provision would greatly accelerate the loss in tax revenues and contribute further to the budget deficits that Congress is apparently anxious to reduce.
But there is indeed much more wrong with 10-5-3. It is highly uneven and capricious in its effects. For some forms of investment, particularly in the automobile industry, depreciation is already very rapid, and three-year capital recovery would be less advantageous than what is currently available. For buildings and long-lived equipment, in public utilities and elsewhere, the tax advantages would be enormous.
What this means for the economy is a tremendous distortion of investment. While business investment that meets a free-market test can be expected to add to productivity, investment now would be directed to tax savings rather than productivity. Some forms would be carried far beyond the point of positive real returns. Others would be starved as the combination of tax incentives and tight money would make credit prohibitively costly or unavailable.
Most hard hit would be less capital-intensive, generally small businesses crowded out in the tax-saving orgy by large capital-intensive firms in older industries. High-technology, research-oriented firms would on balance suffer as the tax changes drew resources elsewhere. And inner cities and urban areas of the Northeast and Middle West would suffer all the more as firms abandoned public and private capital to reap tax advantages in new investment in the suburbs and the Sun Belt.